China is experiencing an acceleration of economic growth. There has been unprecedented capital formation in 2003--in excess of 40% in the first and second quarters, which is one of the highest rates on record. Similarly, there has been an unprecedented growth of credit. Credit outstanding increased by 1.9 trillion renminbi in the first half of 2003, compared with about 900 billion renminbi in the first half of 2002. Credit growth has been expanding at an enormous pace, more than twice that of last year. There has also been very rapid growth in China's foreign trade.

These developments are inter-related. The credit growth has facilitated the high rates of capital formation, which in turn facilitated high rates of growth in the economy. The relative openness of the economy has attracted huge quantities of imports, which grew at a record rate in the first eight months of last year. The period of accelerated growth has perhaps been a policy decision on the part of the leadership to counter the severe acute respiratory syndrome (SARS) crisis. China's foreign exchange build-up has also contributed to this process.

There are enormous consequences of this growth pattern. On the positive side, gross domestic product growth is continuing at a very high rate. Trade growth is very positive. Imports in the first eight months were up by more than 40% as investment accelerated. Export growth is lagging behind a bit, at 33%. China is undoubtedly going to emerge as the third-largest trading economy in the world, set for the first time to go ahead of Japan and rank behind the United States and Germany. This is an extraordinary emergence that is beginning to transform trade flows, particularly in the Asian region.

The positive consequences are easy to see; the adverse ones are less discernible and will emerge only over time. There is a high possibility of declining efficiency of resource use, because the investment has been at such an extraordinarily high rate. There are likely to be more non-performing loans, because credit quality must have deteriorated, given the huge acceleration of growth. This has big fiscal implications for the Government.

Inflation is beginning to rise. It is obviously still low, and most people are not concerned about it, but if credit growth continues for a few more quarters there is a risk that inflation will increase well into double-digits. There is little doubt there is excessive investment in certain sectors. Property is top of the list, followed by several manufacturing sectors and perhaps steel.

The challenge, particularly for the People's Bank of China, is to rein in credit growth without jeopardising rapid economic growth. Revaluing the renminbi might contribute to this. One of the contributors to the rapid growth of credit has been that the banks have built up huge quantities of excess reserves in the process of buying up foreign exchange reserves over the past 18 months. The central bank has sold about 1 trillion renminbi into the market. This has built up bank balances, and the banks have excess reserves and the finance available for additional loan growth. The central bank has been working to sterilise some of the growth of the domestic money supply but it has only been partly successful. As reserves continue to build up, the challenge will become even greater.

The second challenge is the need to develop a more effective financial system. We are perhaps witnessing a period in which progress and commercialisation of the banking system has been set back. Loan growth has been far too excessive, credit quality almost certainly must have gone down, and the cost of recapitalising and rebuilding the banking system is probably higher than it was only a few quarters ago. It is a trade-off between the short-run goal of sustaining economic growth in the face of SARS and weak global growth--the pressure that has been behind the policy on excessive credit growth--and the long-term need to create an effective system of intermediation for the very high savings rates in the domestic economy.

Critical to an effective financial system is further interest-rate liberalisation. It is scarcely surprising that the private sector in China does not get enough capital from the banking system. Banks cannot price risk.

If you cannot price risk you are not much of a bank. You are going to keep lending to the same old traditional state-owned customers, because that is the safest thing to do. If the loan is not repaid then the Ministry of Finance is going to come along and make you whole. The Chinese have a strategy: liberalise big deposits first and smaller ones later; liberalise the deposit side first and the lending side later. But it is going very slowly, and if that continues, the problems may become unmanageable.